I'm a partner at Atlas Venture, a biotech-focused early stage venture capital firm, where I focus on helping start and fund emerging companies. You can follow me on Twitter @LifeSciVC and my blog at www.LifeSciVC.com. Email me at bruce@atlasventure.com.

With today’s announcement of Roche’s deal with Spero Therapeutics LLC (here), and last month’s news regarding Biogen’s deal with Ataxion (here), we’ve added further momentum to our strategy of working closely with larger BioPharma partners to create innovative “external R&D” models around the development of new medicines.

Structured option-to-buy deals are of course not new to the industry, and I’ve discussed them on this blog before (here in particular); the Ataxion and Spero deals are presumably somewhat similar to deals like Resolve-Takeda, Sideris-Novartis, or PharmAkea-Celgene, among many others (though I don’t know the specifics of the latter set). We believe this type of deal will be an important component and contributor to early stage venture capital going forward, and thought it useful to review the background and characteristics of these structured deals.

Both Spero and Ataxion were founded by Atlas in 2013 as part of our seed-led strategy (here), and these new option-based collaborations establish tight working linkages with our new Pharma partners. In the past few months, both deals met the clear seed-stage “signals” we hoped for around scientific progress, talent aggregation, and now, with these collaborations, market traction, supporting their “graduation” into the broader portfolio and aligned with further the financing and acceleration of these companies.

These two deals represent the continued evolution of our initiatives to partner with larger players in the industry to help them build “prospective pipelines” via external R&D collaborations. These efforts were formalized in 2010 when we kicked off our Atlas Venture Development Corp initiative (here), which gave rise to both Arteaus Therapeutics with Eli Lilly (here) and Annovation Pharma with Medicine’s Company (here). Shire’s deal with a Nimbus Discovery’ subsidiary (here) around lysosomal storage disorder program is also similar, and derived from the Shire-Atlas Rare Disease Alliance (here). All of these deals involve the partner purchasing an option to acquire the company/program upon delivery of key future milestones.

To help illustrate the nature of these deals, and option-to-buy structures more generally, here are seven themes common we’ve seen that serve as a loose framework for future deals for us. Each of these collaborations:

Pursue highly innovative pre-clinical programs within single-asset entities. Ataxion and Spero, like Arteaus, are each working on a focused therapeutic program, addressing a first-in-class novel mechanism; Annovation is targeting a best-in-class profile. The nucleating assets when we began Ataxion, Spero, and Annovation were sets of lead series in the midst of drug discovery and optimization campaigns. Reasonable preclinical confidence in rationale from in vivo animal models was in hand. Arteaus was a “late stage” deal for us, focused on an IND-ready mAb program out of Lilly against CGRP. Its worth noting that Spero is an LLC-holding company (described here), so there could be future anti-infective assets in their own sub-entities.

Operate as virtual, lean startups with little fixed cost infrastructure. None of these startups have their own dedicated labs. Instead, all leverage significant and important academic partners and CRO collaborators, aligned in some cases through equity relationships. Arteaus had five team members, including part-timers, when it exited last month; Annovation, Ataxion, and Spero all have (or will soon) similar or smaller team footprints. Their burn rates are almost entirely dedicated to moving the projects forward rather than turning on the lights.

Embrace Big Bio/Pharma partners who add real value. VCs and entrepreneurs like to joke about “value-add” from the former (here). In this case, we truly believe our partners are bringing more to the table than the financial structuring of the option. In most cases, they are heavily involved in the projects from an advisory level, and in several instances our partners have brought significant in-kind services to the deal itself (e.g., screening compound files, lead optimization resources, preclinical model expertise, clinical and regulatory guidance). Finding the right partner for each project is key to its eventual success.

Provide an attractive equity capital efficiency. All of these programs should be able to achieve their critical milestones on significantly less than $20M in equity capital, and in some cases a small fraction of that. Further, material non-dilutive capital infusions from our partners will help to push most of these projects forward with less impact on the ownership structure. This helps Atlas and other founders to maintain meaningful ownership at time of the exercise of the purchase option (and thus projected liquidity), and sets an attractive post-money valuation in the event we “go long” with the story.

Preserve the potential for top-decile, non-correlated returns. As I’ve noted in the past, these deals are structured in a way that provides for cash-on-cash returns commensurate with historic “top-decile” outcomes in venture capital. The risk-adjusted returns, integrating conservative assumptions of attrition and such, have to be >3x for us to engage in a transaction like this. They also need to access the “right-sided tail” of the distribution curve through downstream economics (e.g., milestones or royalties). Importantly, these deals offer significant portfolio diversification with a “non-correlated” element: these deals don’t require active an IPO window or appreciable public market appetite. That may not be relevant today, but public markets ebb and flow and having some diversification in the portfolio should help to improve returns.

Offer an enhanced capital velocity. The timelines for candidate nomination and development work across these deals, even with expected delays of plans-hitting-reality, should all be in the 2-3 year time frame; this is typically the window for the option. As holding periods in venture capital are on average in the 6-7 year range (here), this shorter duration to initial liquidity offers compelling “capital velocity” (or the cycling of capital) back to investors and their LP’s. These shorter times convert the cash-on-cash returns mentioned above into very attractive IRRs.

Maintain optionality around an independent “go long” path for the future. Regardless of our partner’s decision around the option, in each case we would be (or would have been with Arteaus) excited to bring company forward to next value creation point independently. The stringency of our initial thesis, and of the “go long” thesis in particular, rests on the robustness of the data signal generated from the asset. If the partner decides against moving forward, there are no encumbrances in these deals that keep us from forging ahead aggressively with future financings.

Those are some of the defining characteristics of these structured deals. Not all programs or technologies are good fits for this kind of deal; but conversely, many assets don’t warrant building a bigger “company” around them and are perfectly suited to this virtually operated, highly networked, and financially-structured R&D investment. Figuring out what company construct is required to bring early stage assets to the right value inflection is critically important – we aim to tailor our models to the assets, not the other way around.

Lastly, it’s worth noting that these structures have particular appeal to certain types of entrepreneurs. First, most the team members in these single-asset deals straddle more than one opportunity – they are able to simultaneously work on several assets at once. Second, the quicker go/no-go here also allows entrepreneurs to invest their time more efficiently; it’s typically evident in 2-3 years whether the asset has met the trigger for the option. Since an entrepreneurs’ time is the most valuable resource in biotech, this “time allocation efficiency” has significant merits.

As we think of building our portfolio of biotech investments at Atlas, deals of this type – structured option-based deals early in the life of a startup – represent roughly a quarter of the capital we’d like to put to work. When combined with deals of other phenotypes (or other worldviews), such as “novel biology platforms”, “drug discovery engines”, or focused pathway/target biology companies, these deals create a blended portfolio that we believe offers attractive return prospects. Time will tell.

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